Do large principal payments reduce monthly mortgage payments?

On home mortgages, a large payment to principal reduces the loan balance, and with it the fully amortizing monthly payment, or FAMP.

FAMP is the level of monthly payment required to repay the mortgage fully over its remaining term. Many borrowers would like a mortgage that drops to the new, lower FAMP after a large payment to principal and are disappointed when they find they don't have one.

The rules governing such adjustments vary with the type of mortgage.

Fixed-rate mortgages. These are the most rigid, in that extra payments do not affect the required monthly payment at all.

For example, if you borrow $100,000 for 30 years at 3 percent, your FAMP is $422. Pay this amount every month, and you pay off the loan in 30 years.

If you make an extra payment of $10,000 in the second month, your payment in the third month and all subsequent months remains $422. Your loan will pay off in the 305th month instead of the 360th month, but until then, you receive no payment relief.

The lender can always agree to modify the contract, and some will do it for a fee.

Mortgages with interest-only options. There is one exception to the rigidity of fixed-rate mortgages. If the loan was interest-only for a period, which many were prior to the financial crisis, the payment should decline in the month following an extra principal payment. For example, if the $100,000 loan at 3 percent was interest only in the second month when the borrower made a $10,000 payment to principal, the interest payment should decrease from $250 to $225 the following month.

In many cases, however, the payment adjustment was delayed because the lender's servicing system could not handle the transaction properly. Such delays could range from a few months to the end of the interest-only period, usually five or 10 years.

Interest-only is no longer an option on prime mortgages.

Adjustable-rate mortgages. With a loan on which the borrower is making the FAMP, extra principal payments change the monthly payment when the rate adjusts. That happens in the 37th month on a 3/1 ARM, the 61st month on a 5/1, the 85th month on a 7/1, and the 121st month on a 10/1.

On the adjustment date, the payment is recalculated using the new rate, the period remaining of the original term, and the outstanding balance, which will reflect any extra payments.

Consider a 5/1 ARM for $100,000 at 3 percent that has a FAMP of $422. That payment holds for the first 60 months, regardless of any extra principal payments made within that period. If the borrower made an extra payment of $10,000 in the second month, assuming the 3 percent rate is unchanged, the new FAMP will be $379, but the borrower must wait until the 61st month to see it.

ARMs become more responsive to extra principal payments after the initial rate period ends.

Home equity line of credit. During a HELOC's initial phase, which usually runs for 10 years, the borrower pays interest only, though on new HELOCs some lenders now require a higher payment. In either case, because the required payment is a percentage of the outstanding balance, a large principal payment results in an immediate reduction in the required payment.

At the initial rate period's end, borrowers enter the payoff period and must begin paying the FAMP calculated over the remaining life of the HELOC, usually 20 years. The payment increase required is often substantial, because in the typical case no or very few principal payments have been made during the first 10 years.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. http://www.mtgprofessor.com.